Oct 24, 2009

Mid 2009, the new appointed ABP chairman Nijpels and - previously - the ABP CFO ten Damme (picture on the right), stated that the relatively new method of MV is inadequate for pension funds.

Both think that valuation of pension funds could be better based on a (seven year) moving average interest rate.Nijpels en Ten Damme are supported in their view by Albert Röell, Chairman of KAS BANK, who advises the Dutch regulator DNB to reassess its policy.

Why MV?At first sight, there seems nothing wrong in calculating the value of a pension fund, on MV basis. Market (consistent) valuation implies that the value of an asset or liability is defined by it's market price. If the market is too thin, a mark-to-model approach can be used....

Clearly MV increased the transparency and accountability of pension funds. However, 2008/2009 show that MV, based on the actual term structure of interest rates, leads to excessive volatility in funding ratios.

Is MV the best method?Of course MV can be a best practice method in helping to define the pension fund value in case of a merger, a takeover or with regard to managing assets. But is MV also the best method for managing the pension fund as a whole, from a board, regulator or 'pension fund member' perspective?

Future certaintyThe first fundamental question is :

can we define the value of long-term( 60 years or more) cash flows at all?

The answer is: No, we can't!. Just take a look at an average CFO, who's proud to present his next quarterly company result with 60% certainty. What would be the certainty of the long-term company result of - let's say - 20 years ahead. Exactly: Almost zero.

It's impossible for anyone, no Nostradamus Actuary included, to predict the compound and correlated long term effects of interest rate, stock market, derivates, inflation, salary increases, mortality, disability, longevity and costs. Therefore, if it's not possible....., don't pretent you can.

Pension fund: Not for SaleSecond important subject for consideration is that a pension fund (in general) is not listed on the stock market. Also, in general, it is not for sale on the market. Therefore, the hourly, daily or monthly calculated MV is only of limited interest with regard to the pension fund's strategy, policy or control.

Neither is MV the right base for monthly adjusting of the contribution rates, funding rates or indexation capacity.

PrinciplesSimply stated, it's important that a pension fund:

can meet its obligations "on the long-term"

is sufficiently liquid to pay his annuities "on the short-term"

Moving averageThe first statement implies that if you take the funding ratio as steering/testing parameter (there are more!), there is - given the mentioned long term uncertainty - no other option than to base the valuation on a more (term dependent) 'moving average' of interest rates in combination with the moving average value development of other asset classes. The choice of the moving average period is critical.

Dead MoneyEven more, if the pension fund is forced to act on basis of MV, it has to keep extra (non-volatile) buffers to withstand the possible effects of non-relevant short-term market fluctuations. On top of this many pension funds tried to downplay their indexation ambition.

The consequence of all this is that MV generates a substantial amount of structural "dead" capital into the balance sheet. "Dead" capital that - besides - is withdrawn from the national economy and therefore weakens the pension fund's country position in the international level playing field.

Paradoxical measuresIn case - due to market developments - the MV goes down , short-term prudential constraints (as enforced or stimulated by the regulator) will moreover endanger the long-term objectives of pension funds. Consequently leading pension funds from the frying-pan into the fire.

There's another interesting aspect that pleads against MV. In general (Dutch) pension funds cannot go bankrupt, as they are allowed to cut back on the participants’ entitlements in extreme (emergency) situations. So the key question is what kind of minimum security level we enforce upon ourselves. Just an example to illustrate this:

ExampleWhat would you prefer:

100% of the yearly pension that you have been promised, on basis of a 125% funding ratio

125% of the yearly pension that you have been originally promised, at a 100% funding ratio target

Remember there is no ultimate warranty whatsoever in either situation.

The only difference is that in scenario A the chance that your entitlements will be cut down is slightly smaller than in scenario B. But this last situation is as hypothetic as it can be, as contributions will be raised first, before any cut down scenarios will be considered.

So its better to use the funding ratio surplus for legalized controlled indexation and pension benefits improvement than as 'dead' money.

A final argument in the war against MV for pension funds is the next illustration .....

ParaDoxLet's take a look at a company called ParaDox.... ParaDox produces parasols (sunshades) for the high season.

In winter, ParaDox produces at full speed in order to achieve a top level inventory at the start of the summer.

In winter, however, hardly any parasols are sold. During this cold season the price of the parasols on the market (in the shops) drops to about 50% of the summer price. Even more, parasols sales go 80% down in winter (cf. long-term investment market).

If ParaDox would apply MV based techniques, it would have to depreciate their current stock to 50% of the (summer)value. Surely ParaDox would go bankrupt. No, every sensible human being, including actuaries, would decide that in this situation it's best to value the stock of ParaDox on basis of the 'moving average' (realized) sales price over one or more recent years.N.B. Even if ParaDox would have one or two 'bad summers', deprecation would not be considered.

If in this ParaDox case it's clear that market valuation (i.c. deprecation) is unwise, the more it must be clear that in a company with long-term obligations and high uncertainties , like a pension fund is, it's naive to operate and steer on basis of MV.

Moving Average PeriodNow that's illustrated that the Moving Average Method (MAM) is preferable above the MV method (MVM) for pension funds, there's still one thing to decide: the 'MAM period'.

If the MAM period is chosen too short, it will suffer the same disadvantages as the MVM.

If it's chosen too long, there's the risk of not being able to adapt fast enough to realistic contribution levels, if needed. In this situation there's also the risk of unintentional intergenerational financial effects. However, these effects can be yearly calculated and translated into a sound policy.

From this perspective it seems reasonable to fix the MAM periode to the average duration of nominal pension liabilities, which is (in The Netherlands) about fifteen years (in real terms, it is even longer).

HopeLet's trust that DNB listens to ABP and KAS BANK, so that 'pension funds' and 'pension fun' become one again!

Jan 7, 2009

How can you be against something that's fair, like "Fair Value"?What could be wrong, valuating a company at market value?

IceComp CaseLet me take you along in a story about IceComp, a fictitious ordinary wholesaler in ice creams.

The daily demand for ice creams turns out to be in line with the outside temperature. In an average summer, with an average temperature of 16°C (about 60°F), IceComp sells 10 million ice creams a year. Annual turnover the past 10 years, $ 20 million with a net margin of 10%.

In order to regulate demand and to maximize profit, IceComp defines the daily ice cream selling price (P) in line with the market by the formula:

P = DAYTEMP / 8

So at 32°C an ice cream will sell at $ 4 and at 16°C it will sell at $ 2 a piece. To always deliver on time, IceComp keeps an average stock of about 2 million ice creams. Based on on the average selling price of the last 10 years, this stock is valued in the balance sheet at $ 4 million, resulting in a fair and trustworthy P&L, that reflects the actual sales level at current prices.

Two years ago, inventory (stock) valuation based on market prices ('fair value'), i.e. the price daily selling price of an ice cream, became mandatory. From that moment on, things started to go wrong.

Consistent with the daily temperature, the daily inventory value starts to oscillate heavily, with explosions and variations up to $ 6 million per month. To the 'surprise' of all stakeholders, equally strong alternating monthly gains and losses are reported. It's crystal clear, the company is no longer 'in control'.

The national supervisor interferes and demands extra securities (funds). Now the monthly P&L of IceComp starts to oscillate even more, as the investment results of the extra securities, that principally do not have anything to do with the core business of IceComp, also start to vary on basis of 'fair value' (market prices) valuation.

Ultimately, lack of confidence from share- and stakeholders drives IceComp into bankruptcy.

ConclusionWhat was meant to be 'intentional Fair', turns out to be 'Unfair' in practice. Valuing balance sheets on bases of daily prices is like playing 'Russian roulette'. It can be compared to making 'climate statements', based on the daily weather forecast.

The analogy to banking, pension and insurance business may be clear. Don't base valuation methods on daily prices, but on a, per product or market defined, 'moving average market price' for a fixed chosen period (depending on product or market cycle).

The current (credit) crisis calls for development of new valuating principles by auditors and actuaries.

Disclaimer

Maggid is an actuarial professional, and like every actuarial professional or human being, he makes mistakes. Maggid encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong.

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